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RECEIVABLES FINANCE: DISTRIBUTION FINANCE

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Distribution finance could do more to support the supply chain if the market understood it better. Historically more of a US channel, it is beginning to enjoy a wider reach. Igor Zax sets out the opportunities

TFR APRIL 2015

Distribution finance is often referred to as floor plan financing or inventory finance.

While ’traditional’ inventory finance was previously based on the industries with well-developed secondary markets for assets, such as the auto industry, it has rapidly expanded where these markets do not exist, such as the technology and telecoms industries. Here, one can argue that the product is essentially receivable finance with the name of inventory finance along with its resulting pricing and structural implications. Of course, this in no way underestimates the importance of ‘true’ inventory finance where inventory is commoditised or specific liquidity is provided through third-party contracts.

An unshaken marketDistribution finance is still a predominantly US-centric market, which includes major players such as GE Commercial Distribution Finance, Wells Fargo, IBM Global Financing, etc. – but with significant global expansion thanks to push by multinational original equipment manufacturers (OEMs). The financing structures used have stayed broadly the

same for the last 40 years, and the margins show a high level of resilience despite improved market conditions and significant tightening of the margins in the respective industries. Large numbers of programmes are OEM sponsored – where the OEM pays directly to the finance company for providing credit to its distributor’s customers.

The finance company often receives a subsidy comparable with a total net margin of a distributor or channel partner. In the computer/electronics industry this is around 1%, which means that the OEM is in fact investing in high-margin financing companies at the expense of its low-margin channel partners.

Change seems possibleA number of trends, however, are potentially challenging the status quo:■■ The level of supply chain integration

and information exchange improved significantly in the recent years, both downstream and upstream (distribution channel). This has reached the stage when many characterised the main OEM role as just “orchestration” of the supply chain. E-invoicing is

becoming more prominent, approval processes more transparent, and visibility is now often available through multiple layers of the channel.

■■ Supply chain financing (SCF) and dynamic discounting are becoming mainstream, supported by multiple banks and platforms. However, both are predominantly driven from the buyer side. Core principle of supply chain finance – separation of credit and performance risk, as well as many technical and legal structures, can be equally applied to distribution finance.

■■ The credit insurance market model shows good capacity and has been applied to new markets. While there are concerns among financial institutions, the major one is that credit insurance does not cover performance risk such as contractual disputes and fraud. This is eliminated in properly structured SCF programs, often even without a need to move to higher-priced specialised credit insurance solutions.

■■ Current distributor finance programmes involve an expensive and time-consuming process of securing the inventory even in industries where the value of such inventory is doubtful. In reality, the programme is nothing more than receivable finance with some unclear additional security.

■■ Distributor finance relies on proprietary process by the provider-receivable process, including SCF, and can be managed via a third-party or even OEM -controlled platform.

■■ For some distributor finance programmes relying extensively on OEM credit support (these often include risk sharing, inventory repurchase guarantees, for example), it is only a matter of time before these are scrutinised from accounting, rating agency and other standpoints.

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Can SCF shape the new distribution finance model?The core question is if the techniques similar to SCF and dynamic discounting can be successfully adapted to replace out-of-date practices in distribution finance.

With SCF, the IT side, effectively capturing the buyer’s approval, and the structural side are essentially the same, as it would be for a buyer-centric programme, while rolling up the programmes would be easier upstream (distribution) than downstream (suppliers). The reason is that core implications such as accounting, covenants, tax, legal issues, etc. are on the seller’s side (one of the core reasons why onboarding is slow on SCF programmes) while the buyer provides confirmations that they are not part of a financing agreement.

Once these are cleared, it can simultaneously benefit the entire channel expect for suppliers, who need to be addressed on individual basis. The seller has at least the same influence over the channel as the buyer has over its suppliers in a traditional SCF programme (the sales team being better positioned to promote the product than the procurement team in the case of the buyer-centric model). A key issue becomes the level of credit risk appetite, where existing distributor finance providers claim an advantage for having specific industry expertise.

As SCF-type structures only separate the credit risk from the buyer, some instruments such as credit insurance, which may have less than perfect performance where risk is commingled, are becoming highly relevant. In fact, it is widely known in the market that some distributor finance providers are using their own credit insurance policies as a backstop. While I have not come across any statistical data on it, anecdotal evidence from various deals shows that in many cases, risk appetite available on credit insurance market – even on uncollateralised basis – equals or exceeds the one available at distribution finance companies, while cost of credit insurance is materially lower than the assumed risk price taken by finance companies.

Credit insurance programmes One of the core reasons for the relatively high-risk appetite within the insurance industry is comparing lower concentration with specialised finance companies, which is counterbalanced by less experience.

This can, in turn, be compensated with information and knowledge shared by the OEM/distributor that often has superior understanding of its vertical. With pricing, there is, to a large extent, a calibration issue – insurers calibrate per diem on actual losses, which were fairly low on short term trade receivables even though the crisis, while bank financiers are working from the models calibrated on loan losses, which were historically significantly higher.

In addition, with insurance pricing, there is often a discrepancy between the lower pricing available directly to corporates and the one available to financial institutions, due to presumed adverse selection and structural features. While SCF platforms address the elimination of performance risk of the seller, credit insurance-enhanced programmes require a monitoring system, such as limit matching, timing for declarations and reporting, to automate policy compliance.

A well-designed programme combining SCF-based structures between OEM/distributor and its channel partners, combined with the appropriate use of credit insurance, allows the construction of a distributor finance programme equivalent, often at substantially lower cost, higher velocity and with a lower administrative burden. Furthermore, the credit insurance market is global, providing alternative solutions of major advantage to global clients by allowing standardised solutions across multiple markets. Many traditional distribution finance providers are essentially local, and therefore not able to take risks outside of their core markets of operation.

Receivables finance model: another alternativeAnother concept that is worth exploring upstream is what dynamic discounting does for downstream. The idea there is to have the same framework as SCF (buyer confirmation and separation of credit and performance risk) but to use the company’s own cash pile to fund it. The two principal differences here are that:■■ downstream is not credit risk for the

buyer, it merely discounts its own obligation to pay; while it is

■■ a relatively more straightforward choice for the seller who discounts invoices at the time cash is needed and there is no need to change the terms of the invoice itself.

However, for a company looking to invest its cash, receivable programmes may also prove to be a good opportunity. These should ideally include:■■ Buyer confirmation. In the same

way as in supply chain finance and dynamic discounting.

■■ Managing excess risk. Longer terms mean larger exposure for the same customers. It’s the same as with the distribution finance structure described above; the credit insurance combined with the buyer confirmation may be an efficient tool.

■■ Pricing mechanisms for terms. That may be addressed through stock keeping units (SKU), or may be some type of dynamic mechanism.

■■ Structure. To ensure extended terms are only available on invoices approved within a short time limit with default terms applicable to any non-confirmed invoices (at the time the invoice is issued it is still uncertain if it may be disputed).

■■ Just as with dynamic discounting, a finance structure can be put in place to finance invoices when/if the company does not want to invest its own cash.

Using modern approaches such as the ones described above should significantly open the distribution finance market and allow financial institutions that are not currently active to build this relatively low-risk and high-margin product in a more efficient way than the current players. This can be done either as a financing product or by participating in captive structures with large OEMs and other clients.

Similarly with supply chain (but differently from factoring), this can be built in a highly efficient core banking product to serve the needs of global OEM clients, and enhanced even further as new technologies develop; it can work on domestic markets such as the US, as well as export markets. Given the growth and increased integration of vertical supply chains, this may as well be one of the best growth opportunities overall in the trade finance world.

Igor Zax is managing director of Tenzor Ltd

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